Friday, February 20, 2009

/PRNewswire/ -- Over the last year, stock, bond, real estate, commodity and other markets have been devastated by fear and panic selling. The destructive forces leading up to this once-every-century bear market are analogous to an awful virus that has attacked and spread across our land more quickly, and infected more people than any other virus in recorded history.

While this virus appeared relatively benign for years, once the fatal contaminants were triggered, the disease brought down its victims in just a few months.

Origin of the Virus

We have traced the origins of the virus to a truly unique village on a small island in the Northeast U.S. by the Hudson River. While this village has realized exponential population growth over the years, its unique characteristic is the very high level of intellect and wealth of the inhabitants.

With such a density of elite and well connected talent, our hope and expectation has been for this village to be a valuable source of creative ideas that will make our country more productive and globally competitive.

Sadly, this has not been the case.

While they have been prolific with the new and creative ideas, whatever productive benefits were created flowed solely to them. They connected with other elites across the nation and around the world that were responsible for large pools of wealth (pensions, endowments, foundations, wealth managers, etc.) and enticed them with the same luring elixir - greed.

We have found that greed, which is an inherent component of everyone's DNA, is the infectious agent that originally created this terrible virus. And, like most human viruses, it is spread by carriers that extract blood from one victim and transport it to the next victim.

Rather than relying on physical contact, this virus has quickly spread around the globe via the Internet, global cell phones and other means of instant communications.

To recognize the origin, connectivity and carrier nature of the disease, we have labeled it the WEBS Virus - Wall Street Elite Blood Suckers Virus.

The Virus Carriers

Are we being a little harsh? Probably so, but we are talking about a hugely destructive force. We are also talking about our business, the investment industry. As Pogo the Possum said, "We have met the enemy, and he is us."

At CornerCap, we believe we remain virus free. The fundamentals of our business are completely transparent and, unlike some advisers, we are subject to regular audits by the SEC.

On that note, the virus was most recently epitomized by Bernard Madoff who reportedly stole $50 billion of investor money in a Ponzi scheme.

It is difficult to comprehend how investors and regulators could have been duped for so long and so much. There is no rationale. The SEC reviews CornerCap in week-long audits every few years. How is it that, year after year, they chose not to examine the Madoff firm?

What about the other virus carriers in the investment industry?

There are many managers, bankers, brokers, and planners whose greed led to excess risk and poor advice. Over-priced bad advice not only destroys value for the client, but it creates unwarranted wealth for the advisor.

In other words, our most feared virus carriers are these investment industry advisors who seem to win even when their clients fail.

Virus Strands

In recent years two strands of this WEBS Virus have emerged. And each of these strands always involve the creation of a bubble in the marketplace which are relatively easy to spot.

There are 'greed-strand' bubbles. These are the more frequent and toxic variety. They typically involve taking more risk than is expected or understood.

There are also 'fear-strand' bubbles, which are also unhealthy, and they usually involve a stampede away from a possible risk.

Right now we are actually in the middle of a fear-strand bubble with the rush to buy "safety" at any cost. This has caused a substantial over-valuation of U.S. Treasury securities.

However, we've also seen several greed-strand bubbles recently.

The on-going housing and subprime meltdown involved investment bankers, mortgage brokers, and many others in the investment industry who were virus carriers.

The tech bubble involved investment bankers, Wall Street analysts, and stock brokers. In a response to the tech bubble, we have seen a growing concentration in alternative assets (hedge funds, private equity, leverage products, etc.) which involved most of the same characters.

While not picking on any particular virus carrier, the investment banker community seem to be the best bubble blowers in the bunch.

To succeed Wall Street needs a continuing cycle of bubbles, i.e. promoting new products to passionate buyers. This process creates incredible wealth - not for the buyer but for themselves.

Like Madoff, these virus carriers only needed to create the appearance of future profits without a commensurate amount of risk, and investors would be willing to reward them with substantial compensation from their pension funds, foundations, endowments, home equity, personal savings, etc. Like Madoff, much of the wealth promised to investors was lost.

The Broader Issue

In a broader sense, this deadly WEBS virus seems to have become part of our society and culture.

We used to be rewarded for making truly useful products. Today, we seem to be more in the business of leveraging, swapping, bundling, layering, and trading financial products with each other. We incur significant costs and waste much of our talented manpower with most products in the investment industry.

Most Wall Street people are honest, hard working professionals. They listen to investors and try to create the products that investors will want to buy. These professionals usually believe in the products they are selling. They believe that their products adequately control risks.

In the research and development (R&D) labs, their models confirmed that more and more leverage would not inordinately increase the risks. Smart professionals creating sophisticated products that seem to satisfy a client need.

What's wrong with that?

As markets oscillate between fear and greed, Wall Street creates new products to solve the most recent problems. So long as investors continue to demand and pay for financial products that exceed reality, these talented professionals will make models that promise to redefine reality.

These were all highly profitable products for Wall Street that offered high expectations for greater profits at more controlled risks for the investor. Few of those profits were realized, especially after paying there exorbitant fees.

What will be the post-housing and subprime bubble products? Be assured, those new products are already in the R&D labs.

The Cure

We do not see greed and fear being controlled, and as such, we see no permanent cure for the WEBS Virus. The cycle will continue to repeat itself.

Uneducable investors will demand new products with promises of profits without the pain of the recent past. Wall Street will create those products and convince the institutional investors of their value.

The new and exciting products will work well initially, and the message will quickly spread from the institutional market to Main Street and around the world. The new financial products will eventually lose their luster and self-destruct.

However, successful investing is not about new and exciting financial products with promises of profits by slicing and dicing other financial products. It is about owning successful business enterprises that produce real profits by actually delivering something useful to their customers.

Successful, virus-free investors will (1) not fall victim to unreasonable promises; (2) demand transparency and understand the product; (3) minimize costs; (4) avoid the use of leverage; and (5) choose morals and substance over promises from talented product purveyors.

At CornerCap, the portfolios that we build and manage for clients meet those criteria. Even though encouraged to do so by others, we avoided leverage, hedge funds, illiquid private equity funds, subprime investments or any security concentrations.

Client success over time requires that risk be the principal focus. When the expectation of return is allowed to trump risk, the client will eventually be nailed by a Black Swan, i.e. an unpredictable financial disaster. However, the investment profession, our virus carrier, will have accumulated sufficient wealth to move on to the next virus strand.

To stay virus free investors will need to avoid those soon-to-come offerings that appear too good to be true.